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Stock-based compensation.

Executive compensation is a highly visible and hotly debated issue. Much of the debate has focused on stock-based compensation, particularly stock options and restricted stock. During the past two years, several events have underscored the importance of this issue to accountants.

In October, 1992, the Securities and Exchange Commission (SEC) issued new regulations governing the disclosure of compensation information in the annual proxy statement. In June, 1993, the Financial Accounting Standards Board (FASB) issued its exposure draft on "Accounting for Stock-Based Compensation." Throughout 1993 and 1994, several business periodicals published surveys of CEO compensation. The 1993 Tax Act imposed restrictions on the deductibility of some forms of executive compensation. Also, compensation and benefits consulting has become established as a major growth market for accounting firms of all sizes.

Table 1 lists several Fortune 50 firms ranked by CEO compensation as computed by the Wall Street Journal and Forbes. The table illustrates how different treatments of stock-based compensation can lead to strikingly different amounts of total compensation. There are three companies (General Electric, Merck and Philip Morris) for which the compensation amounts differ by more than $10 million. For Merck, the difference in compensation amounts is almost six times as large as the compensation reported by Forbes. There are also marked differences in rankings under the two different methods of calculating total compensation. For example, Dow Chemical and Ford Motor both moved down 13 positions in the rank ordering, whereas Tenneco moved up 11 positions.

Accountants can profit from an understanding of why such large differences exist and how they can be reconciled. An understanding of the sources of these differences will [TABULAR DATA OMITTED] enhance the ability to assist in the development of compensation policies, compliance with SEC proxy statement disclosure requirements and implementation of the FASB's reporting and disclosure requirements. Unfortunately, accountants who are not compensation specialists seldom have the time needed to wade through the morass of literature dealing with stock-based compensation. In many cases, the non-specialist's previous experience with stock-based compensation is limited to a familiarity with Accounting Principles Board Opinion 25.

This article will assist the non-specialist in acquiring a working knowledge of current developments in accounting for stock-based compensation. It will also show how the identification of the measurement date for stock options and restricted stock is the key to making sense out of stock-based compensation.

Stock Options and Restricted Stock

Stock options give the executive the right to make future purchases of the company's shares at a pre-determined price, known as the striking (or exercise) price. Four dates are of special significance. The grant date is the date on which the options are awarded to the executive. The vesting date is the date on which the executive acquires the right to use the options to purchase shares. The exercise date is the date on which the executive actually uses the options to make a purchase of shares. The expiration date is the last date on which the options can be exercised. Most executive stock options do not become exercisable (i.e., vest) until two or three years after the grant date.

Restricted stock consists of shares of company stock, the ownership of which does not pass to the executive unless and until specified conditions are met. Typical conditions include the passage of time and the achievement of individual and corporate performance goals.

There are two important dates associated with restricted stock. The grant date is the date on which the award is made, i.e., the date on which the company enters into an agreement with the executive that he or she will receive the specified number of shares at the specified future date provided that the required conditions have been met. The vesting date is the date on which ownership of the shares passes to the executive.

SEC Disclosure Regulations

In October, 1992, the Securities and Exchange Commission (SEC) issued new regulations governing the content and format of annual proxy statement disclosures pertaining to compensation of the company's five most highly paid executives. The regulations require the disclosure of salary, bonus, other annual compensation, restricted stock grants, number of restricted shares vesting during the year, stock option grants, payouts under long-term incentive plans, stock option exercises and other compensation.

Stock option disclosures are centered on the grant date and exercise date. For each of the company's five most highly paid executives, the proxy statement must disclose the number and value of stock options granted and exercised during the year. The number of stock options granted during the year is reported in the compensation table in the proxy statement.

The SEC requires that stock options be valued under one of two methods. The first method, known as Black-Scholes, estimates the probability distribution of future stock prices, obtains an expected value by weighting each possible price according to its probability and then values the option by taking the present value of the expected value.

As an alternative to the Black-Scholes model, the SEC allows companies to estimate the value of options granted by assuming growth rates of 0%, 5% and 10% in the price of the stock. The value of the options granted is the difference between the exercise price (the price at which the option holder is entitled to purchase the stock) and the ending price based on each growth assumption. Options exercised during the year are valued at the difference between the exercise price and the market price of the stock at the time the options were exercised. In addition to these disclosures, the proxy statement must also report the value of all holdings of executive stock options that are "in the money," i.e., options for which the exercise price is lower than the year-end market price.

The disclosures for restricted stock are centered on the grant date and vesting date. For each of the company's five most highly paid executives, the proxy statement must disclose the number of restricted shares granted and vested during the year. The compensation table in the proxy statement must also disclose the dollar value of the shares granted. Grants of restricted stock are valued at the share price on the grant date.

FASB Exposure Draft

Accounting for stock-based compensation has a long and contentious history. At the present time, accounting for stock-based compensation is governed by APB Opinion No. 25. One of the most heavily criticized features of APB 25 is that it does not require the recognition of compensation expense for executive stock options or for grants of restricted stock. In June, 1993, the FASB issued the exposure draft entitled, "Accounting for Stock-Based Compensation."

The primary difference between APB 25 and the exposure draft is that the latter requires the recognition of compensation expense for the value of executive stock options and restricted stock. FASB constituents who oppose the recognition of expense for stock-based compensation have made dire predictions concerning the effects of the proposed standard. Specifically, there has been speculation that companies will reduce or even eliminate stock option plans in response to the requirement that compensation expense be recognized.

The FASB has responded by pointing out that it would not be rational for employers to reduce or eliminate stock option plans that have the intended motivational effect of improving the results of operations after recognizing the associated expense. The FASB has also expressed skepticism that employers will indiscriminately reduce or eliminate stock option plans solely in response to a new accounting standard. However, in addition to heavy criticism from the private sector, the U.S. Senate recently passed a resolution urging the FASB to abandon the entirely project. At this time, the future of the FASB's proposal for accounting for stock-based compensation is in doubt.

Even among those who agree that compensation expense should be recognized, there has been disagreement with the FASB on the subject of how (and when) the compensation expense should be measured. The FASB has proposed that the measurement date for the value of the options or shares should be the date of grant. On the grant date, options are to be valued using a valid option pricing model and restricted shares are to be valued at the market price. Dissenters have argued that stock-based compensation should be valued on the exercise date or vesting date. Under the FASB proposal, compensation expense is recognized over the vesting period.

Unlike the SEC, the FASB does not permit companies to value option grants simply by assuming various growth rates for the price of the stock. For publicly-held companies, the value of options granted must be computed using an accepted option-pricing method. The two techniques that are most widely used in practice are the Black-Scholes model and binomial model. The Black-Scholes model is also permitted by the SEC and was discussed earlier.
Table 2:
Summary of CEO Compensation Data for Merck, Inc., From Surveys by the Wall
Street Journal and Forbes

Wall Street Journal
 Salary $ 1,125
 Bonus 1,400
 Salary + Bonus 2,525
 Long-Term Compensation 0
 Total Direct Compensation 2,525
 Present Value of Option Grants 15,027
 WSJ Total $17,552

 Salary + Bonus $2,525
 Other 6
 Stock Gains 0
 Forbes Total $2,531

Reconciliation Between Surveys
 Forbes Total 2,531
 Plus: WSJ
 Present Value of Option Grants 15,027
 Less: Forbes - Other Compensation (6)
 Equals: WSJ Total 17,552

Note: Compensation amounts are in thousands.

The binomial model offers two advantages over Black-Scholes: it uses simpler mathematics and it tends to provide more accurate results for stocks that pay large dividends. Inexpensive; user-friendly, PC-based software is available to estimate option values under either the Black-Scholes or binomial method. The software does not require (or presume) a knowledge of advanced mathematics.

Executive Compensation Surveys

The business press also has focused on stock-based compensation. Several business periodicals have published surveys of the compensation of CEOs of large publicly-held corporations. Most of the information used in the surveys was extracted from the annual proxy statements.

Despite the use of a common source of information, the findings and conclusions of the surveys sometimes differ sharply. Table 1 illustrates some of the differences for individual companies. The surveys reach different general conclusions as well. For example, the Wall Street Journal found that the median 1992 CEO pay of $1.5 million represented an increase of about 8% over 1991, whereas Forbes concluded that CEOs took a 1992 pay cut of 14%. Fortune found a 1992 increase of about 7%.

The next section uses an example taken from two different compensation surveys to illustrate the importance of measurement dates in determining the amount of stock option compensation.

Example: Merck, Inc.

Merck, Inc., was chosen to serve as the example because it is an extreme case of the effects of different choices of the measurement date for stock options. Table 2 shows the compensation amounts for the CEO of Merck, Inc., as reported by the Wall Street Journal and Forbes. As evident from Table 2, the two total compensation amounts differ by more than $15 million. The key to reconciling between compensation surveys is to recognize that each survey uses different measurement dates to assign a value to stock-based compensation. The Forbes survey reports as "Stock Gains" the value of options exercised during the year. Forbes does not report the value of options granted. In contrast, the Wall Street Journal reports the value of options exercised as one component of "Long-Term Compensation" and reports options granted as the "Present Value of Option Grants."

Thus, the difference in total compensation is almost entirely attributable to the use of different measurement dates for stock options. Forbes ignores the grant date and measures stock option compensation on the exercise date. The Wall Street Journal measures stock option compensation at both the grant date and the exercise date. Table 2 also reconciles between the two surveys. As seen in Table 2, the difference in total compensation is due almost entirely to the fact that Forbes does not include the value of options granted in its total compensation amount.

Neither of the two surveys fully complies with the measurement scheme specified in the FASB exposure draft, but the Wall Street Journal comes closest. The amount of CEO compensation that Merck would recognize under the FASB exposure draft is equal to the $2,525 reported as "Total Direct Compensation," plus the portion of the $15,027 in option grants amortized in 1992, plus the $6 in "Other" compensation reported by Forbes.

Summary and Main Points

Stock-based compensation involves a broad range of accounting issues. It is important to remember that identifying the measurement date is the key to making sense out of stock-based compensation. When advising clients on compensation policy, SEC disclosure requirements or the FASB exposure draft on stock-based compensation, accountants must be clear as to which measurement date is being used. Under the FASB exposure draft, both stock options and restricted stock are measured (valued) on the grant date. Compensation expense will be recognized from the grant date until the options or shares vest. Expense will not be recognized for the exercise of options. This approach differs from the methods used by the SEC and by compensation surveys.

Eramete H. Griner, CPA, PhD, is assistant professor of accounting and Mary S. Stone, CPA, PhD, is Ernst and Young professor of accounting in the Culverhouse School of Accountancy at the University of Alabama in Tuscaloosa.
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Author:Griner, Emmett H.; Stone, Mary S.
Publication:The National Public Accountant
Date:Feb 1, 1995
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